ELSS Mutual Funds – Meaning, Benefits & Ways to Invest

Out of the many different types of mutual funds available in the Indian financial markets, ELSS is consistently among the most popular. Investing in such a fund is a good way to gain diversified exposure to the Indian equity market. Wondering what ELSS is? Here’s a comprehensive guide explaining the meaning of ELSS, how it works and the various benefits you get by investing in it.

What are ELSS Funds?

ELSS is an acronym for Equity Linked Savings Scheme. As the name implies, it is a type of mutual fund that predominantly invests in the equity market. Since the returns are market-linked, the fund is ideal for long-term wealth creation.

ELSS funds have two primary features that set it apart from traditional mutual funds - the presence of a lock-in period and the ability to save tax. Unlike other equity-oriented funds, ELSS has a mandatory lock-in period of 3 years, during which you cannot withdraw the investment you made in the fund.

Also, the investment you make in an ELSS fund can be claimed as a deduction under section 80C of the Income Tax Act, 1961 to reduce your total taxable income. The maximum amount you can claim as a deduction during each financial year is Rs. 1.5 lakhs. The ability of ELSS to reduce your tax liability is why many investors refer to it as tax-saving funds.

How Do ELSS Mutual Funds Work?

Now that you’re aware of what ELSS is, let’s look at a hypothetical example to understand how the tax saving fund exactly works.

Assume your goal is long-term wealth creation. To achieve this objective, you choose to invest a lump sum amount of Rs. 2 lakhs in an Equity Linked Savings Scheme that invests around 90% of its assets in the equity market.

The Rs. 2 lakhs that you invest in the ELSS fund will be locked in for three years from the date of investment. During these three years, you cannot withdraw the amount you invested. In addition to this, you get to claim Rs. 1.5 lakhs as a deduction from your total taxable income under section 80C of the Income Tax Act.

Let’s say that your total taxable income is Rs. 10 lakhs, placing you under the 20% income tax slab under the old income tax regime. Now, since you’re eligible to deduct Rs. 1.5 lakhs under section 80C, you can effectively bring your total taxable income down to Rs. 8.5 lakhs. This means that you would get to save tax of about Rs. 30,000 (Rs. 1.5 lakhs * 20%). That said, keep in mind that this deduction is only available for the financial year in which you made the lump sum investment in the ELSS fund.

Once the 3-year lock-in period ends, you can choose to either withdraw your investment along with any returns. Alternatively, you can also choose to stay invested for as long as you wish or until your long-term financial goals are satisfied.

Advantages of ELSS Mutual Funds

ELSS offers a plethora of advantages. Let’s look at some of the key benefits you get to enjoy by investing in such a fund.

• Short Lock-In Periods

  ELSS has one of the shortest lock-in periods compared to other traditional savings and investment schemes like the Public Provident Fund (PPF), 5-year tax-saving fixed deposit and the National Pension System (NPS).

• Potential for Higher Returns

  The meaning of ELSS is ‘Equity Linked Savings Scheme’, which effectively means that the returns from the fund are dependent on the performance of the equity market. The returns from ELSS are more likely to be higher than other traditional investment options provided the market performs well.

• Tax Benefits

  You get to claim the investment in an ELSS fund to the tune of Rs. 1.5 lakh per financial year as a deduction under section 80C of the Income Tax Act, 1961. Additionally, the returns from the fund are classified as Long-Term Capital Gains (LTCG). In the case of LTCG, only gains above Rs. 1 lakh during a financial year are taxed at the rate of 10%.

• Convenience

  Equity Linked Savings Schemes are very flexible. You can either choose to invest a lump sum amount or start a Systematic Investment Plan (SIP), where you invest a fixed sum of money at regular intervals.

Who Should Invest in ELSS Mutual Funds?

If you’re a salaried individual, you should consider investing in ELSS. It not only has the potential to produce higher returns compared to other traditional investment options but can also lower your tax liability. Since you already have a stable source of income in the form of a salary, the three-year lock-in period that the fund has may not be a deterrent.

On the other hand, you can also consider investing in an Equity Linked Savings Scheme if you’re an investor who is new to the stock market. Most ELSS funds invest in a basket of different stocks, reducing the overall investment risk through diversification. And instead of investing a lump sum, you can set up a Systematic Investment Plan (SIP). A SIP enables you to invest a fixed amount regularly for a predetermined tenure.

Things to Consider Before Investing in ELSS Funds

As an investor, simply knowing what these tax-saving funds are may not be enough. You also need to be aware of the factors you need to consider before investing in them. Here’s a quick overview of some of the key things you need to account for.

• Fund Performance

  One of the first factors you need to consider before investing in ELSS is the fund’s performance. Always consider investing in a fund that has consistently performed over the years across different market scenarios. That said, it is essential to note that past performance doesn’t guarantee future returns.

• Fund House History

  Looking into the history of the fund house or Asset Management Company (AMC) is equally important. The AMC must be experienced enough and have a good track record of managing the fund.

• Expense Ratio

  The expense ratio is the fee that an AMC charges for managing a mutual fund. It is expressed as a percentage of your total investment amount. The higher this ratio is, the lesser your returns are likely to be. Therefore, when investing in ELSS, remember to opt for a fund with a low expense ratio.

• Fund Manager

  The fund manager is an experienced professional tasked with the responsibility of managing the mutual fund. The manager’s actions can have a profound impact on the performance of the fund. Before you invest in an ELSS fund, make sure to thoroughly analyze the credentials of the manager and his track record of managing the fund.

3 Ways to Invest in ELSS Funds

There are three different ways to invest in an Equity Linked Savings Scheme. The benefits you stand to gain may vary slightly depending on the method you choose.

Growth Option

You only get the benefit of capital appreciation if you choose the growth option when investing in ELSS. Dividends that are declared by the stocks in the mutual fund’s portfolio will not be disbursed to you.

Dividend Option

With the dividend option, you get to enjoy both capital appreciation and dividends. The dividends will be paid out to you as and when they’re declared.

Dividend Reinvestment Option

When you choose the dividend reinvestment option, you get capital appreciation as well as dividends. However, instead of the dividends being paid out to you, they’re reinvested into the fund.

Conclusion

With this, you must now be well-versed with what ELSS funds are and their various advantages. Before you invest in an Equity Linked Savings Scheme, remember to consider factors like your investment objectives, risk tolerance and investment horizon. This will help you determine whether you should invest in such a fund or not. That said, if liquidity is what you prefer, it is advisable to look for other alternative investment options since the three-year lock-in period of ELSS can be quite limiting.